Rate Freeze To Cool Mortgage Meltdown

In the wake of 2007's rising foreclosure rates, the U.S. government negotiated with a series of mortgage service companies, Citigroup, Countrywide Financial, Washington Mutual and Wells Fargo (or the Hope Alliance) to create a "Mortgage Rate Freeze" program to alleviate the financial strain of resetting interest rates for subprime borrowers in 2008. (For background reading, see the Subprime Mortgages Feature page.)

In theory, this program is designed to not only benefit a targeted group of homeowners, but the economy as a whole by reducing foreclosures and, therefore, downward pressure on real estate prices. There is a wide range of estimates on the number of people this plan will help from the 1.2 million estimated by the Mortgage Bankers Association to as few as 145,000 estimated by The Center for Responsible Lending. In this article, we'll shed some light on the rate freeze plan that aims to slow the mortgage meltdown and save singed and struggling homeowners.

The PlanThe plan is pretty straightforward and rests on the cooperation of the Hope Alliance to set aside the terms of existing subprime mortgage contracts and not reset interest rates for as many as 1.2 million loans (according to the Mortgage Bankers Association) in 2008. This rate freeze would last for a period of five years, which would keep rates below reset values and keep costs manageable for these borrowers. (For more on adjustable-rate mortgages, read This ARM Has Teeth.)

This freeze would also allow borrowers an opportunity to refinance their mortgages at a lower rate with a traditional 80% equity loan, assuming there is sufficient price appreciation and/or time for principal repayments over the next five years to create the 20% in equity necessary for the lower rate refinancing.

Of course, there are a few caveats for subprime borrowers. First off, this plan will only be available to owner-occupied properties, meaning investors are not meant to participate in this program. Secondly, borrowers must be in relatively good standing on their existing loan, having never missed any payments, been late by more than 60 days during the life of the loan, or been more than 30 days overdue at the time they apply for the "rate freeze". Furthermore, this plan will only be available to those borrowers who are deemed incapable of making payments should their interest rates reset.

Rate Freeze RationaleEssentially, this "rate freeze" program is designed to not only to buy time for subprime borrowers, but for the economy and credit markets as well. In theory, this plan will decrease the number of foreclosures, thereby reducing downward pressure on real estate prices as fewer homes flood the market.

Furthermore, this plan is designed to alleviate pressure on mortgage-backed debt markets by reducing defaults, bolstering confidence in the market and increasing the willingness of banks and investors to make mortgage investments. This is key to maintaining the supply of credit and growth in the rate of homeownership, which helps to maintain demand in the housing market.

Let's take a look at the pros and cons of the mortgage rate freeze plan.

Pros

The obvious benefit of the rate freeze plan is for subprime borrowers who are facing an interest rate reset in 2008. This plan could freeze their payments for five years, providing a lot of breathing room for those facing a payment they can't afford. Ideally, during this time the homeowner will be able to build up enough equity, either through price appreciation or principal payments, to refinance at a lower rate, which generally requires the home owner to have about 20% equity in his or her home. (For more insight, read Mortgages: The ABCs Of Refinancing.)

Another benefit is that this plan could reduce the number of foreclosures by homeowners who are unable to make payments. This saves the lenders or investors who purchased these mortgages from having to try and recoup their costs by selling in a weak market. (To learn more about this side of the mortgage market, read Behind The Scenes Of Your Mortgage.)

From the standpoint of subprime borrowers, the upside of this plan is that it represents a redistribution of wealth (the difference between mortgage payment rates) from investors to homeowners in the form of lower mortgage payments - at least lower than what the borrowers agreed to pay. However, there is also a benefit to lenders in that by keeping the rates lower (more manageable), the likelihood of foreclosures, which represent a worst-case scenario for borrowers and lenders, decreases.

Cons

There may be a fundamental flaw in the execution of this plan in that little effort has been made to economically motivate investors to cooperate. Mortgage service companies have no legal power to arbitrarily renegotiate the terms of a mortgage contract. So in essence, all the government has done is to convince mortgage service companies to refuse to raise interest rates according to the terms of the underlying mortgage agreements, violating their duty to investors. As a result, this plan could generate a series of investor lawsuits, as has already been acknowledged by U.S. Treasury Secretary Henry Paulson.

However, one could also argue that the Hope Alliance is actually acting in the best interest of investors by precluding costly foreclosures. In other words, getting some money is better than getting no money at all. Of course, this is something the courts will ultimately decide.

Another criticism of the plan is how it will affect capital markets and investors' perceptions of mortgage-backed securities. Essentially, this plan establishes a precedent for government intervention in private mortgages by coercing mortgage service companies to violate the terms of the agreement at the investors' expense. As such, it could lead many homeowners to continue to make poor investment decisions with the hopes of bailouts. It could also make investors wary of investing in the mortgage market as the government could simply come in and modify their investments, which in this case has lowered their returns. (For related reading, see Profit From Mortgage Debt With MBS.)

ConclusionIf you've been burned by the meltdown or you may get singed in the new year, you would be crazy not to accept the free money offered by this plan. If you believe you qualify, call the 1-888-995-HOPE hotline that was established by the government to facilitate the rate freeze plan.

Again, for those that will benefit from this plan, it can be a great deal. However, if you're an investor who is getting stiffed on interest payment or a subprime borrower who needs a home loan sometime down the road, this rate freeze plan may work against you.